August 7, 2013

Private Equity Alert

A recent decision by the First Circuit Court of Appeals in Federal Appeals 1 Court Concludes III, L.P. et al. v. New England Teamsters & Trucking Industry may have important implications for funds that own portfolio PE Funds are companies with underfunded pension obligations. In its decision, the Potentially Liable court held that a private equity fund that had an investment in a portfolio for Pension company that was managed by the fund’s general partner and its manager Obligations was a “trade or business” with potential joint and several liability under the of Portfolio Employee Retirement Income Security Act of 1974 (ERISA) for that portfolio Companies company’s withdrawal liability from a multiemployer pension plan. As such, the private equity fund could be required to use its assets to fund the pension By Paul Wessel and Verity Rees liability if the additional “common control” requirements were satisfied.

“Controlled Group” Liability under ERISA Under Title IV of ERISA, significant pension liabilities can arise upon the withdrawal by a participating employer from a union multiemployer pension plan (at issue in the Sun Capital case), as well as upon the termination of an underfunded single employer pension plan (i.e., in a “distress” or “involuntary” plan termination under ERISA). Under the “controlled group” liability rules of ERISA, an entity other than the direct employer is also responsible for these liabilities, on a joint and several basis, if the entity is (i) a “trade or business” and (ii) under “common control” with the employer, which generally requires common ownership of at least 80 percent. The Sun Capital decision deals with the first such test. In this case, two private equity funds sponsored by the same firm, Sun Capital Advisors, Inc. (Sun Capital), acquired a 100 percent ownership interest in Scott Brass, Inc. (SBI) in 2007: “Fund IV” acquired a 70 percent interest, and “Fund III” acquired a 30 percent interest. These respective ownership interests apparently were arrived at with a view toward ERISA’s 80 percent common control test. When SBI subsequently withdrew from a union-sponsored multiemployer pension plan, the plan sought to collect SBI’s withdrawal liability from the two funds under ERISA’s controlled group liability rules.

Private Equity Fund as a “Trade or Business” Reversing the lower court, the First Circuit held that Sun Capital Fund IV constituted a “trade or business” and thus could potentially be treated as

Weil, Gotshal & Manges LLP Private Equity Alert

a member of the controlled group for purposes of Weil News ERISA. In reaching its conclusion, the court held that ■■ Weil was a joint winner of Law Firm of the Year – Sun Capital was more than merely a passive investor Transactional at the Financial News Awards (which would not be deemed a “trade or business” for Excellence in Private Equity Europe 2013 under ERISA) by applying the “investment plus” test to ■■Weil was one of only three firms ranked in the top the activities of Sun Capital and Fund IV. This test looks band for private equity in Chambers Global 2012 at whether, unlike a mere passive investor, the investor and one of only three firms ranked in the top band is also exercising control over the management and for private equity buyouts in IFLR 2013 operations of that company. The court acknowledged ■■Weil won the 2013 IFLR Americas Award for Private that this is a facts and circumstances test and Equity Team of the Year requires a case-by-case determination. ■■Weil advised Fidelity National Financial and Thomas In applying these standards to reach its conclusion H. Lee Partners in connection with the $2.9 billion here, the court noted that, although none is dispositive, acquisition of Lender Processing Services, Inc. a number of factors with respect to Fund IV (the 70 ■■Weil advised Thomas H. Lee Partners in connection percent owner), which would seem to be typical for with its acquisition of CompuCom, a leading IT services a private equity investment, indicated the presence and solutions specialist of a “trade or business”:

■■Weil advised Lindsay Goldberg and its portfolio ■■The fund’s LP agreements and private company Trygg Pharma Group in its $345 million placement memos stated that the fund was sale of Epax, a manufacturer of high concentrate actively involved in the management omega-3 supplements, to FMC Corporation, a US and operation of its portfolio companies. publicly traded diversified chemical company ■■The general partners were empowered through ■■Weil advised CCMP Capital Advisors and its portfolio their GP agreements to make hiring, firing, and company Milacron, a global plastics industry leader, compensation decisions for employees and agents in connection with Milacron’s acquisition of Mold- Masters, a leading global hot-runner manufacturer of the portfolio companies.

■■ ■■Weil advised OMERS Private Equity on its £390 Sun Capital’s employees controlled the SBI board million acquisition of Civica, the specialist systems of directors and provided SBI with management and business process services provider and consulting services.

■■Weil advised Charterhouse Capital Partners on its ■■The general partners received management acquisition of Germany-based Armacell Group, a fees from the fund and a percentage of profits manufacturer of engineered foams and the world leader as compensation, and the fund received a direct in the market for flexible technical insulation materials economic benefit from active management of SBI ■■Weil advised Partners in by an entity related to the general partners that connection with its acquisition of the five corporate collected management fees from SBI that partially training businesses of Informa plc, a Switzerland- offsetting the management fees paid by the fund to based academic publishing, business information the general partners. and events group In making its determination, the court attributed the ■■Weil advised Berkshire Partners in connection with its management activities engaged in by the general acquisition of a majority interest in SRS Distribution Inc., partner and the Sun Capital managers to the fund, the fourth-largest residential roofing distributor in the US ignoring their separate legal status. ■■ Weil advised HgCapital in connection with its €303 The court did not make a determination on whether million disposition of ATC Group BV, an Amsterdam- Fund III (the 30 percent owner) constituted a “trade or based fiduciary and administration services company business” and remanded the claim to the district court.

Weil, Gotshal & Manges LLP August 7, 2013 2 Private Equity Alert

“Evade or Avoid” Transactions to be engaged in a “trade or business,” non-US limited partners could recognize “effectively connected income,” The court also remanded the case to the district court and tax-exempt limited partners could recognize to determine the issue of whether either of the funds “unrelated business taxable income.” Additionally, was under “common control” with SBI for ERISA management fees paid by a private equity fund to purposes – that is, even if the funds are a trade or its manager may become fully deductible as trade or business, whether the 80 percent common control test business expenses rather than investment expenses would be satisfied based on the facts here. that are subject to various limits on deductibility by The court did conclude however that a provision of certain taxpayers. However, the court in Sun Capital ERISA allowing transactions to be disregarded where suggested that the term “trade or business” as used for a primary purpose is to “evade or avoid” liability purposes of ERISA does not have the same meaning as did not apply in this case, even though Sun Capital the term used for federal income tax purposes, and the had invested in SBI on a 70/30 basis between the court limited the scope of its decision to ERISA Section two funds in an effort to prevent establishment of a 1301(b)(1). As such, while the Sun Capital case makes controlled group. The court observed that while ERISA various references to the trade or business standard would allow certain transactions to be disregarded, it for federal income tax purposes, absent further statutory does not contemplate the imposition of a “fictitious” or judicial developments, we do not believe that the Sun transaction for this purpose (e.g., establishing 100 Capital conclusions regarding “trade or business” status percent ownership by a single investor). in the ERISA context extend to long-standing federal income tax interpretations of that standard as applied Additional Observations to non-US, tax-exempt, and other investors in private equity funds. The Sun Capital case may have significant implications for private equity firms, private equity We will continue to stay apprised of this matter and fund investors, and their portfolio companies. For update you on any further developments in this area. one, if a single fund holds more than 80 percent of the equity of a portfolio company, that fund and even 1 No. 12-2312, 2013 WL 3814984 (1st Cir. July 24, 2013) its other 80 percent-owned portfolio companies may now become liable for the pension liabilities of the company, if the Sun Capital precedent is followed. This will put additional emphasis on due diligence, Fiduciary Duties Rule pricing, indemnities, and structuring in transactions By Default involving significant potential pension liabilities. By Michael Weisser and Andrew Arons In addition, private equity funds have structured investments to minimize liability for portfolio company This article provides an update to the November pension obligations by allocating ownership to 2012 Private Equity Alert in which we highlighted the numerous investment vehicles with no one vehicle ambiguity that existed under Delaware law as to whether owning 80 percent or more of the interest in the fiduciary duties applied to directors of a Delaware limited underlying portfolio company. Time will tell if the liability company by default (i.e., when the LLC members district court in the Sun Capital case addresses this were silent on the issue). As discussed in that article, issue. Therefore, the verdict is not out yet on whether the Delaware Limited Liability Company Act makes this practice passes muster and insulates private clear that the members of a limited liability company equity funds from portfolio company pension liability. can contractually tailor fiduciary duties in any number of ways (by eliminating them altogether, expanding It is also uncertain whether the Sun Capital case will them, or otherwise modifying them), and the commonly have any tax implications for private equity funds. For held belief for years has been that traditional corporate federal income tax purposes, if a fund were deemed fiduciary principles apply in a limited liability company

Weil, Gotshal & Manges LLP August 7, 2013 3 Private Equity Alert by “default” if the members did not take such action in a limited liability company by “default”. Although the to explicitly eliminate, expand, or otherwise modify ambiguity has been eliminated, our key takeaways in such fiduciary duties. However, in the Delaware case the November 2012 Private Equity Alert continue to of Gatz Properties, LLC v. Auriga Capital Corp., the apply: in every transaction involving the formation of Delaware Supreme Court (in reviewing the Chancery a Delaware limited liability company, deal professionals Court’s decision) indicated that the question of and lawyers should affirmatively and clearly provide in whether the Delaware Limited Liability Company Act the applicable contract whether fiduciary duties exist has “default” fiduciary duties has not been answered or not, and if they do exist, to what extent. While the to date in Delaware, which created the ambiguity amendment is effective as of August 1, 2013, it applies under Delaware law. retroactively. Therefore, deal professionals and lawyers would also be well advised to review the operating The ambiguity has since been eliminated by the agreements and other similar contracts relating to their recent adoption by the Delaware General Assembly existing limited liability companies to ensure they are of an amendment to Section 18-1104 of the Delaware aware of what fiduciary duties, if any, may apply to the Limited Liability Company Act that makes it crystal directors of such companies. clear that traditional corporate fiduciary principles apply

Private Equity Alert is published by the Private Equity practice group of Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, +1 212 310 8000, www.weil.com.

The Private Equity group’s practice includes the formation of private equity funds and the execution of domestic and cross-border acquisition and investment transactions. Our fund formation practice includes the representation of private equity fund sponsors in organizing a wide variety of private equity funds, including buyout, , distressed debt, and real estate opportunity funds, and the representation of large institutional investors making investments in those funds. Our transaction execution practice includes the representation of private equity fund sponsors and their portfolio companies in a broad range of transactions, including leveraged buyouts, merger and acquisition transactions, strategic investments, recapitalizations, minority equity investments, distressed investments, venture capital investments, and restructurings.

If you have questions concerning the contents of this issue, or would like more information about Weil’s Private Equity practice group, please speak to your regular contact at Weil, or to the editors, practice group leaders or contributing authors:

Editors: Doug Warner (founding editor) Bio Page [email protected] +1 212 310 8751

Michael Weisser Bio Page [email protected] +1 212 310 8249

Contributing Authors: Andrew Arons (NY) Bio Page [email protected] +1 212 310 8160

Verity Rees (NY) Bio Page [email protected] +1 212 310 8643

Michael Weisser (NY) Bio Page [email protected] +1 212 310 8249

Paul Wessel (NY) Bio Page [email protected] +1 212 310 8720

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Weil, Gotshal & Manges LLP August 7, 2013 4